On January 27, 2016, the US Court of Appeals for the Sixth Circuit in Village Green I, GP v. Federal National Mortgage Ass'n (In re Village Green I, G.P.), affirmed the district court's decision that while the debtor's motives in impairing a de minimis class of creditors under section 1124(1) of the Bankruptcy Code were irrelevant, the artificial nature of that impairment meant that the the debtor had not proposed its plan in good faith under section 1129(a)(3) of the Bankruptcy Code ( (6th Cir. Jan. 27, 2016)).

Village Green (Debtor) owned an apartment building that was subject to an $8.6 million mortgage. The Debtor owed monthly mortgage payments of $55,000 to Fannie Mae. After missing a payment in 2009, the Debtor filed for Chapter 11 bankruptcy. Under section 362(a) of the Bankruptcy Code, the bankruptcy court stayed any creditor action against the Debtor which prevented Fannie Mae from foreclosing on the building. The building was the only asset owned by the Debtor, and the Debtor's only other creditors were its former lawyer and accountant whose total general unsecured claims were less than $2,400 (Minor Claimants).

The Debtor proposed a plan of reorganization that would:

A court may confirm a Chapter 11 plan over the objections of a dissenting class of creditors if the plan satisfies the Bankruptcy Code's cramdown conditions (§ 1129(b), Bankruptcy Code). One of these requirements, found in section 1129(a)(10) of the Bankruptcy Code, is that at least one impaired class, without counting the votes of insiders, has accepted the plan. Under section 1124(1) of the Bankruptcy Code, a plan impairs a class if it alters the legal, equitable, and contractual rights of the claim holders. This requirement ensures that at least one group hurt by the plan favors the plan.

The bankruptcy court found that because the Minor Claimants were paid after a 60 day delay, their claims were considered impaired under the plan. Therefore, it held that acceptance by the Minor Claimants satisfied the requirement under section 1129(a)(10) and it confirmed the plan.

Fannie Mae appealed to the district court, which vacated the confirmation order and remanded for a determination whether, among other things, the Debtor had proposed the plan in good faith. On remand, the bankruptcy court found that the Debtor had proposed the plan in good faith because it was "economically justified in rationing every dollar," and therefore the court re-confirmed the plan. The district court again vacated and remanded, finding that the Debtor had proposed the plan in bad faith, and directing the bankruptcy court to dismiss the case and lift the automatic stay. The Debtor then appealed to the Sixth Circuit.

The Sixth Circuit held that:

Courts have been split over whether to allow artificial impairment (see Article, Artificial Impairment: Legitimate Practice or Mere Artifice?). In this case, the Sixth Circuit allowed artificial impairment, but disallowed the debtor's manipulation by finding a lack of good faith in proposing its plan.

This case is consistent with the US Court of Appeals for the Fifth Circuit's recent decision in Western Real Estate Equities, L.L.C. v. Village at Camp Bowie I, L.P. (In re Village at Camp Bowie I, L.P.) (see 710 F.3d 239, 245-46 (5th Cir. 2013) and Legal Update, In re Village at Camp Bowie I: Fifth Circuit Affirms Cramdown Plan Despite Artificial Impairment). There, the court also literally interpreted the meaning of impairment under section 1124(1) of the Bankruptcy Code and found that artificial impairment does not constitute bad faith as a matter of law under section 1129(a)(3) of the Bankruptcy Code. However, in that case the court did not engage in a good faith analysis of the plan at issue and only affirmed the bankruptcy court's finding of good faith in the absence of clear error.